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The kindness of Strangers

Via Yves Smith's, Evans Pritchard from the Telegraph outlines how, in a funny twist of fate, the american financial system depends on the good will of its past ideological enemies: china, russia and the petro-states.

Basically the analysis goes like this: the subprime mortgage crisis is morphing into a credit crisis, that is threatening to reach the US Treasury level. We have a full-blown wage-price inflation in emerging economies, which combined with the continued slide of the dollar, would make US Treasuries less attractive to these foreign investors. Flight to safety be damned, the dollar and foreign inflation will give it the coup de grace. Problem is, a large chunk of that debt is usually funded from abroad.

Roughly $1.5 trillion of Fannie and Freddie AAA-rated debt - as well as other US "government-sponsored enterprises" - is now in foreign hands. The great unknown is whether foreign patience will snap as losses mount and the dollar slides.

Hiroshi Watanabe, Japan's chief regulator, rattled the markets yesterday when he urged Japanese banks and life insurance companies to treat US agency debt with caution. The two sets of institutions hold an estimated $56bn of these bonds....

But the lion's share is held by the central banks of China, Russia and petro-powers. These countries could all too easily precipitate a run on the dollar in the current climate and bring the United States to its knees, should they decide that it is in their strategic interest to do so.

This bit about the GSE's is tough to swallow, essentially the US govt has just guaranteed the loans, what are they complaining about? 200 bips for free? The run on the dollar however is an interesting option. Albeit a political one. US investors have staged runs on other currencies in the past, are we counting on the good behavior of Mr Putin, who according to the same article sees Russia engaged in a new cold war with the US?

Merrill Lynch said foreign governments had added $241bn of US agency debt over the past year alone as their foreign reserves exploded, accounting for a third of total financing for the US current account deficit....

Global inflation is now intruding with a vengeance as well. Much of Asia is having to raise rates aggressively, drawing capital away from North America. This may push up yields on US Treasuries and bonds, tightening the credit screw at a time when the US is already mired in slump.

This is really bad news for the economy on US rates alone, limiting the FED field of action to stimulate the economy with lower rates. Furthermore most of our lifestyle is funded by debt that ends up showing as trade deficit, because it is truly funded by outsiders. No ticky, no laundry, this will add tremendously to the credit crunch. Not only are we witnessing deleveraging of M4 internally but if money flows reverse trend away from the US, we will witness the birth of a negative feedback loop at a monetary level bringing about severe deflationary pressures. As inflation sparks elsewhere, the US will further slump into recessionary deflation due to massive drops in monetary levels and no wage pressure. What a bad combo: high commodities lower prices on everything else.

The FED has already said clearly in the case of the GSE's: FORGET THE EQUITY MARKETS, SAVE THE BOND MARKETS.

A least one guy gets it:

Russia's deputy finance minister, Dmitry Pankin, said the collapse in the share prices of Fannie and Freddie over the past week was irrelevant because their debt has been effectively guaranteed by the US government under the rescue package.

And I am sure they are praising the comrades over in the US FED for making good on their private loans with public money. The conspiracy theories one can read about the FED do not seem so far fetched. But truth be told i am not sure they had a choice.

And for this last bit of irony.

China is regarded as a more reliable partner, with a greater desire for global stability....

What a funny and precarious situation. What a mess. The emergence of a middle class in the BRICs sparking global growth anew is the one scenario that can save us all (tm).

I bet on stagflation in BRICs, stagnation or recession with no long-term inflation in the US and potentially EU (depending on unions) as the oil shock of 2008 will not spark a wage price spiral but the Great Delevaraging of 2009 will wreck havoc on the land.

Bottom line: this is bad for equities, it is not even good for bonds (could be).
The day US Treasuries are contaminated by the sub-prime virus is the day I really freak out, 28 days later style.

Read the original blog entry...

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